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WorldView 1Q 2015Dislocations: The dollar, Europe and the deflation question

MARKETINSIGHTS

• Given the volatility of currencies, fixed income investors may want to make sure their global bond exposure is hedged against currency risks. However, for equities, the story is less clear, particularly if a long-term view of prospects for the domestic currency seem dimmer than appear to be priced into local fixed income markets.

• The ECB’s recent moves have changed the game for Eurozone markets. Their actions are clearly positive for equities but lower oil prices, an improving credit cycle, a weaker currency and more supportive fiscal policy, are arguably an even bigger story. Investors should also consider European countries outside the Eurozone, which provide attractive equity and fixed income opportunities.

• A strong U.S. dollar combined with weak commodity prices has increased investor concerns over deflation risk. A disinflationary, rather than deflationary, environment is still our base case scenario for emerging markets (EM) in 2015, as EM central banks still have plenty of room to ease their monetary policies. However, aggressive rate cuts are not likely, as many EM governments are aware that structural reforms are the key to more sustainable economic growth in the future.

2 | WorldView | 1Q 2015

Dr. David P. Kelly, CFAManaging Director Chief Global Strategist J.P. Morgan Funds

David M. Stubbs Executive DirectorGlobal Market Strategist,UK & EuropeJ.P. Morgan Asset Management

David Stubbs is a Global Market Strategist for J.P. Morgan Asset Management in the UK and Europe. Based in the London office, David is responsible for delivering research-driven insights on the global economy and markets to both retail and institutional clients in the UK and Europe. He is a frequent guest on CNBC, Bloomberg and other major market outlets.

Prior to joining J.P. Morgan, David worked at MRB Partners in New York where he was a senior macro strategist, and he held similar roles at Heitman Securities in London and at the United Nations Department for Economics and Social Affairs, amongst others.

David holds a M.Sc. in International Political Economy from the London School of Economics and a Ph.D. in Economics from The New School for Social Research in New York. He is an FRM and CMT Charter Holder.

Grace Tam, CFAExecutive DirectorGlobal Market Strategist,AsiaJ.P. Morgan Asset Management

Grace Tam is a Global Market Strategist for J.P. Morgan Asset Management in Asia. Based in Hong Kong and an employee since 2004, Grace is responsible for delivering market analysis and insights as well as communicating the investment views and outlook of J.P. Morgan Asset Management to internal and external clients throughout the Asia Pacific region.

She is a frequent speaker at investment conferences as well as on media in Hong Kong. She also writes a weekly column for financial newspaper and is widely quoted in the press.

Grace began her career with the Bank of Tokyo-Mitsubishi UFJ where she was a currency and options trader. She obtained a Bachelor’s degree and a Master’s degree in Economics from the Chinese University of Hong Kong and is a CFA charterholder.

W O R L D V I E WThe key to successful investing is not seeing the future with some kind of mythical vision — it is seeing the present with clarity. This is more true today than ever, in a world recovering from financial crisis, rife with political discontent, extreme monetary easing and deep-seated investor prejudice. In this quarterly publication, we strive to provide clarity by examining the key issues shaping the global investment landscape, while identifying risks and opportunities for investors.

PORTFOLIO DISCUSSION: Title Copy HereMARKETINSIGHTS WorldView | 1Q 2015

David Kelly is the Chief Global Strategist for J.P. Morgan Funds. With more than 20 years of experience, David provides valuable insight and perspective on the economy and markets to thousands of investment professionals and their clients. He is a keynote speaker at many national investment conferences. David is also a frequent guest on CNBC and other financial news outlets and is widely quoted in the financial press.

Prior to joining J.P. Morgan Funds, David served as Economic Advisor to Putnam Investments. He has also served as a senior strategist/economist at SPP Investment Management, Primark Decision Economics, Lehman Brothers and DRI/McGraw-Hill. David is a CFA charterholder. He also has a PhD and MA in economics from Michigan State University and a BA in economics from University College Dublin in the Republic of Ireland.

J.P. Morgan Asset Management | 3

Love the market, hate the currency: Foreign exchange hedging in 2015Dr. David P. Kelly, CFA, Chief Global Strategist

IntroductionFor global investors, one of the most important investment decisions is always whether to hedge currency exposure or not. This seems particularly relevant today given the sharp currency movements over the past two years. For example, in 2013, the MSCI-Japan index produced a sparkling 55% total return measured in Yen, but just 27% when measured in U.S. dollars. Last year, a U.S. investor betting on the MSCI-Germany index saw a local currency gain of 3% get transformed by a falling Euro into a 10% loss in dollars. Clearly, in retrospect, hedging currency exposure would have been a good idea for many U.S. investors over the past two years.

V I E W P O I N TThe importance of the currency hedging decision is under-scored by the significant outperformance of Japanese and European stocks measured in local currencies relative to dollar-denominated returns in 2013 and 2014 respectively.

EXHIBIT 1: GLOBAL EQUITY MARKET RETURNS

Local currency and U.S. Dollar returns for selected regional and country indices, 2013 and 2014

Country/Region Local USD Local USD

Regions/Broad Indexes

U.S. (S&P 500) — 32.4 — 13.7

EAFE 27.5 23.3 6.4 -4.5

Europe ex-U.K. 24.2 28.7 7.4 -5.8

Pacific ex-Japan 16.5 5.6 5.8 -0.3

Emerging Markets 3.8 -2.3 5.6 -1.8

MSCI: Selected Countries

United Kingdom 18.5 20.7 0.5 -5.4

France 22.1 27.7 3.6 -9.0

Germany 26.7 32.4 2.8 -9.8

Japan 54.8 27.3 9.8 -3.7

China 4.0 4.0 8.3 8.3

India 8.6 -3.8 26.4 23.9

Brazil -3.0 -15.8 -2.8 -13.7

Russia 7.5 1.4 -12.1 -45.9

Source: Standard & Poor’s, MSCI, Factset, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.

That being said, should investors be hedging foreign currency exposures today? One way to address this question is to divide it into three sub-questions. First, in “normal” market conditions, does it make sense for an investor to hedge currency exposure in fixed income and equity markets? Second, how should this normal operating procedure be adapted to the current unusual situation where all the major developed central banks are essentially operating a zero interest rate policy and two of them, the ECB and the BOJ, appear intent on devaluing their currencies? And third, given how far the U.S. dollar has already risen and current economic fundamentals, is it possible to formulate a medium-term view of where the dollar might be headed?

Before addressing any of these questions, however, it is worth revisiting hedging basics to understand the costs and benefits of foreign currency hedging. In addressing all of this, for ease of exposition, we take the perspective of a U.S. investor, although clearly both the general issue of hedging and the prospects for the U.S. dollar are important to all global investors.

The benefits and costs of currency hedging Without hedging, an American buying Eurozone stocks is really taking two investment positions, one on the stocks themselves and the other on the Euro. This year, while prospects for improvement in European corporate fundamentals look quite good, many worry that the Euro could fall further against the dollar, negating positive local currency returns. So how do you avoid the currency risk?

EXHIBIT 2: U.S. DOLLAR INDEX

Broad Currency Real Effective Exchange Rate index, Jan. 1973- Jan. 2015

140

130

120

110

100

90

80'73 '79 '85 '91 '97 '03 '09 '15

Source: Federal Reserve, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.

2013 2014

Hedging – Arbitrage strategies are highly complex. Such trading strategies are dependent upon various computer and telecommunications technologies and upon adequate liquidity in markets traded. The successful execution of these strategies could be severely compromised by, among other things, illiquidity of the markets traded. These strategies are dependent on historical correlations that may not always be true and may result in losses. Investors should consider a hedge investment a supplement to an overall investment program and should invest only if they are willing to undertake the risks involved. A hedge investment will involve significant risks such as illiquidity and a long-term investment commitment.



While most hedging is done through forward or futures markets, the principle involved can be shown using a simpler example. By allocating, say, $100,000 to an unhedged Eurozone equity fund, the investor is effectively taking long positions in both the equity fund and the Euro. To neutralize the latter, she could simultaneously borrow $100,000 worth of Euros for a year and invest them in a dollar-denominated deposit account. This amounts to a $100,000 short position in the Euro.

If, at the end of the year, the Euro has fallen by 10%, the investor will suffer a $10,000 loss on the currency exposure of the stock transaction but gain a similar amount by having to use fewer dollars to pay back the Euro denominated loan. Two points should be noted. First, the cost of the currency hedge, or carry, is determined by relative interest rates. If European interest rates were higher than those in the U.S., the European loan would be accumulating interest faster than the U.S. deposit account would generate it, resulting in a positive carry cost. Of course, if it were the other way around, the investor would actually be receiving net interest on the currency hedge. Second, most simple hedging techniques will not provide a perfect hedge because we can’t tell ahead of time the extent of any gain or loss in the local currency equity investment.

Hedging in normal conditions Bearing this in mind, should an investor normally hedge international equity or fixed income positions? The right way to think of this is to consider the currency position in an international investment as an investment in its own right with a cost, an expected return and a contribution to overall portfolio volatility. If we assume that interest rates are the same in the domestic and international market then the cost of hedging is essentially zero, so this boils down to a question of expected return and impact on portfolio volatility. If we further assume that it is impossible to forecast which way the currency might move, then taking a foreign currency position is likely just adding to overall portfolio volatility while not providing any additional expected return. For this reason, many portfolio managers of developed country, high-quality bond portfolios prefer to hedge. As noted in a 2010 IMF working paper, not hedging tends to add a lot of volatility to relatively low-yielding fixed income portfolios without providing the benefit of higher expected returns.1

It is also not as clear when the hedge involves a large carry cost, such as a U.S. investor trying to hedge currency exposure

to a high-interest country such as Brazil, since the literature suggests that high interest rate currencies do not depreciate as much as predicted by interest rate differentials.2 Indeed, this historic regularity is responsible for much of the carry-trade activity of recent decades, where investors would borrow in a low-interest rate market (for a long time Japan) to invest in higher return markets, assuming that any appreciation of the Yen should be minor relative to the currency advantage.

Finally, it is not quite so clear for very long-term investors since, in theory, real exchange rates (that is exchange rates adjusted for relative inflation) are mean reverting. If the dollar shoots too high, then U.S. exports will fall, imports will rise, capital will flow out of the United States and the dollar will come back down again. However, the persistence of a U.S. current account deficit for 32 of the last 33 years suggests that this reversion may be just a little too slow for the average real-world investor.

Hedging in a world of over-active central banks Hedging is essentially an opt-out of a currency view and there is a certain logic to avoiding taking a position on currencies. It is, after all, a zero sum game with a zero expected return over cash and significant volatility. Furthermore, it is probably more likely than not to increase overall portfolio volatility.

Today, however, many investors believe there is a way to forecast currencies by recognizing the implications of further rounds of QE from Europe and Japan even as U.S. QE has come to an end. I believe that, while QE has succeeded in depressing long-term interest rates around the developed world, it has not stimulated economic growth. Low short-term interest rates have starved consumers of income, while requiring those planning for retirement to save even more to have a chance of having their accumulated wealth provide them with a reasonable income in their later years. Businesses have been reluctant to invest despite low long-term interest rates because they doubt future consumer demand. Banks have been unwilling to lend, in part because of the paltry profits available on loans given low long-term rates, and economic activity in general has been supressed by the uncertainty created by central banks continually assuring economic agents that the economy is, in fact, weak and in need of further monetary medicine.

However, it must be admitted that in the case of Japan in 2013 and more recently in Europe, the prospect of QE has led to a very welcome slide in their currencies. This can not only stave

1 Currency Hedging for International Portfolios, Jochen M. Schmittmann, IMF Working Paper, June 2010.2 The literature is also full of interesting explanations for why this might be the case. See, for example, (Almost) A Quarter Century of Currency Expectations Data: Interest

Rate Parity and the Risk Premium, Menzie D. Chinn, NBER, September 2014.


It is also important to consider the long-term challenges facing the U.S. economy. At the current pace of economic growth, within the next two years the U.S. unemployment rate will be in the low 4%’s, requiring any further employment growth to come from labor force growth rather than the depleted rolls of the unemployed. Given the demographic problems at the core of the slowdown in U.S. labor force participation and mediocre productivity growth, the U.S. economy is likely to slide to below 2% real GDP growth. In addition, given their very late start on monetary tightening, there is a risk that the Federal Reserve will over-tighten too late in the cycle and then have to return to easing mode to try to rescue the U.S. economy from another recession.

V I E W P O I N TFor long-term equity market investors it may make sense to forgo currency hedging if a secular slowdown in U.S. growth relative to the rest of the world allows both foreign currencies and foreign equity markets to outperform.

By contrast, the Eurozone should see a pickup in growth this year but, starting with an unemployment rate of 11.4%, has years of above-trend growth before it hits capacity constraints. Meanwhile, emerging markets are restrained by neither slow labor force growth nor weak productivity and could see strong growth even as the U.S. slows down. In this kind of scenario, the very forces which appear to be boosting the dollar today could be undermining it in two years.

For long-term investors, it is quite possible that the currency risk seen in international investments today will be seen as a currency opportunity in a few years time. Moreover, it is important to think about the reason for international diversification in the first place. U.S. Investors often ask whether they need to invest in international companies at all since there are so many domestic companies with huge overseas operations. But the reason for international diversification is not just to increase your exposure to the rest of the world, but also to reduce your exposure to your home country in case of domestic economic disaster. A similar case can be made for foreign currency exposure. Today, the U.S. is leading the global expansion, attracting capital from around the world and seeing a sharp increase in its currency. However, if this story changes over time and other nations take up the mantle of global leadership, investors may well want to be fully exposed not just to their stocks and bonds, but also to their currencies.

off the somewhat overblown monster of deflation, but can also promote stronger export growth. Conversely, the U.S. central bank is being pushed by a tightening labor market into raising interest rates, likely starting in the middle of this year. This is also widely expected to put further downward pressure on currencies of many emerging markets. If these central banks stick to their playbooks, it is possible that the prospect of a further flood of Euros and Yen into the global market could push the U.S. dollar up further in 2015.

If this was truly a very likely scenario, then investors might well want to not only hedge their currency exposure to international investments, but perhaps even over-hedge allowing their portfolio to benefit from a rise in the dollar from these levels.

The long-term case for a balanced currency view For long-term investors, however, it is not necessarily a great idea to avoid all foreign currency exposure in favor of the dollar.

First, the dollar has already risen a great deal. The real effective exchange rate of the U.S. dollar, as calculated by the Federal Reserve, has risen 15 from its low of July 2011, and global measures of purchasing power suggest that it is now expensive relative to the Yen and the Euro.

Moreover, note that in 2013, when the dollar in real terms was more than 10% cheaper than today, the U.S. still ran a current account deficit equal to 2.4% of GDP, while the Eurozone ran a surplus of 2.4%, Japan had a surplus of 0.7% and emerging markets as a group had a surplus of 0.8%. While higher U.S. oil production and lower global oil prices should both help the U.S. with its trade balance, it is likely that the sharp increase in the U.S. exchange rate since then will lead to a gradual widening of our trade deficit in 2016 and beyond.

EXHIBIT 3: RELATIVE CURRENT ACCOUNT BALANCES

Current Account Balance as a % of GDP, 1997-2014

6

4

2

0

-2

-4

-6

-8'97 '99 '01 '03 '05 '07 '09 '11 '13

%

Eurozone

EMU.S.

Japan

Source: IMF, Factset, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.

International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations.



Europe’s investment future: QE and beyondDavid Stubbs, Global Market Strategist, UK & Europe

IntroductionImportant moves by the European Central Bank (ECB) have improved sentiment towards European assets in recent months. This article outlines the actions that have been taken and discusses other factors which will be central to shaping Eurozone markets in the coming year. Furthermore, we discuss the options open to investors who wish to gain exposure to European assets outside of the Eurozone.

QE is important for European stocks but other factors are also in playIn January, frustrated by slow growth and low inflation, the ECB launched its long-awaited sovereign quantitative easing programme. The key planks of the announcement were:

• €60bn per month of asset purchases between March 2015and September 2016. The ECB had previously only been ableto purchase asset-backed securities (ABS) and covered bonds,but will now also include European institutional debt andsovereign debt in its asset buying program.

• Further, potentially open-ended, asset purchases are possible,as the ECB promised to keep buying “until we see a sustainedadjustment in the path of which is consistent with our aimof achieving inflation rates below, but close to, 2% over themedium term.”

• The ECB also pledged to provide even cheaper funds to banksby removing the 10 basis point premium on the TargetedLTRO program. Funding will now be priced in line with therepo rate, potentially providing a boost to the program,which has struggled to gain traction since being announcedlate last year.

The expanded asset buying program’s impact on markets is multifaceted and is only one among several related factors that will support better prospects for investors this year. Large scale asset purchases by the ECB create other dynamics in the market: pushing the Euro down, forcing investors into riskier assets, and supporting a more accommodative fiscal policy stance.

V I E W P O I N TThe ECB’s patience with the Euro area economic recovery and inflation outlook has run out. On January 22, the central bank announced a major new program of asset purchases. The ECB changed the monetary policy game in Europe by committing to €60bn per month of asset purchases for 18 months starting in March 2015. The length of the program could extend even further if inflation targets are not met.

Sovereign bond yields should fall...right?Holding investor behavior stable, purchases of government bonds should raise bond prices and therefore reduce their yield. However, in some past instances of quantitative easing in the United States, bond yields were higher at the conclusion of the program than when it began. The common explanation for this is the increased inflation expectations that the policy induced. Indeed, the focus on such market-derived expectations has arguably been greater in the lead up to Europe’s quantitative easing program than before the Federal Reserve initiated its sovereign bond purchase initiatives. Hence, the mark of success for the program could, paradoxically, be higher bond yields not lower, as investors require higher yields to invest in a future that they perceive is more inflationary than before.

Whatever happens to government bond yields, other assets classes seem sure to benefit through the “portfolio balance effect” which occurs when investors who have sold their bonds to the ECB turn around and buy other assets. This is a key part of the transmission mechanism for quantitative easing. By pushing investors into other assets classes, policymakers are improving liquidity and pricing in those assets classes and, all else being equal, increasing the wealth of those holding the assets. Equities are one such asset class that should benefit. Both directly, as investors sell government bonds and buy stocks (particularly higher-yielding ones in an effort to replace income streams) but also indirectly, as listed firms take advantage of the demand for corporate debt securities to issue new paper at low rates. This new debt can then be used to retire older and more expensive loans, or return capital to share holders through increased dividends or buybacks. This indirect channel is arguably the more important of the two, as most sellers of government bonds will be fixed income managers who are not able to buy stocks within their current mandate. If a sufficient amount of firms carry out this arbitrage then it can be expected to be a significant tailwind to push stocks higher.


EXHIBIT 1: MSCI EUROPE INDEX: GEOGRAPHICAL SOURCE OF REVENUES

Europe

AsiaRoW*

Americas

11%

10%

25%

54%

Source: MSCI, FactSet, J.P. Morgan Asset Management. *RoW denotes revenues coming from the world excluding Europe, Asia and the Americas. Data as of January 31, 2015. For illustrative purposes only.

However, an even more significant effect of QE is the impact it can have by depressing the value of the Euro, as around half of MSCI Europe earnings come from outside the Eurozone (Exhibit 1). The market had already priced in the ECB action by forcing the Euro lower in the months leading up to the announcement (Exhibit 2), and so the direct effect on foreign denominated earnings can be expected to the be apparent in company earnings throughout the coming year.

EXHIBIT 2: ECB BALANCE SHEET AND THE EURO

€ trillions, real broad effective exchange rate (REER)

'07 '08 '09 '10 '11 '12 '13 '14

115

110

105

100

95

90

1.2

€

1.6

2.0

2.4

2.8

3.2

ECB balance sheet(rhs, inverted)

Euro REER (lhs)

Source: ECB, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only.

QE not the only factor in play Despite the important impact of QE on equities, it is far from being the only determinant of asset class performance going forward, especially as its effectiveness is questionable given the low levels of interest rates already prevailing in the market. Oil’s headline-making decline has helped shape financial markets in recent months and, unless a rapid and sustained snap-back occurs, the impact will be felt throughout the year. As a net importer of oil, the Eurozone economy is a beneficiary of the decline in crude prices, even if it has exacerbated concerns over deflation. Despite some increase in demand, as people change their energy consumption behavior, the decline in the price of energy should boost spending in other goods and services, fuelling growth and equity earnings away from the energy space.

EXHIBIT 3: CRUDE OIL PRICES

$ per barrel

'10 '11 '12 '13 '14

140

$

120

100

80

60

40

Brent Crude -46%WTI -47%

Change in 2014

Source: FactSet, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only.

V I E W P O I N TThe recent fall in the region’s currency looks set to continue. The depreciating euro should boost the value of equity earnings from outside the single currency area. Together with lower energy costs, looser credit standards, improving loan demand and reduced fiscal contraction, the weaker currency creates a supportive backdrop for European risk assets.

The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition — sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries, such as changes in economic or political conditions. Equity securities are subject to “stock market risk” meaning that stock prices may decline over short or extended periods of time.



Other past policy actions should also create a healthier climate for growth and equity earnings, particularly changes to bank supervision and more accommodative fiscal policy. Last year saw a series of actions taken by policymakers to assess the health of the banking system and set it up for a more stable and active future. European banks were subject to two parallel exercises: the Asset Quality Review conducted by the ECB, which assessed the holdings of individual banks, and the stress tests conducted by the EMU, which subjected those holdings to a range of adverse scenarios. The results, while not perfect, were encouraging and confirmed the stability of their counterparties and their ability to meet capital requirements that would be enforced upon them. Then, late last year, the ECB took over supervision of the Euro area’s largest banks, providing further regulatory consistency and clarity. The combination of these efforts has now set the ground for banks to lend. Easier supply is being met by greater demand as shown by the ECB’s own credit demand survey in Exhibit 4. This combination should support growth going forward, and with it, corporate earnings.

EXHIBIT 4: EUROPE CREDIT DEMAND

Net % of banks reporting positive loan demand

'04 '05 '06 '07 '09 '10 '11 '12 '14

100

Stronger loandemand

50

0

-50

-100

-150

Overall corporate (lhs)

Consumer credit (lhs)Housing loans (lhs) Weaker loan

demand

Source: ECB, Eurostat, FactSet, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only.

Finance minsters should also play their role in supporting a recovery in the Eurozone economy. After years of severe austerity that hampered growth, a more considered, but still responsible, approach to fiscal policy is being pursued in the Eurozone. With the hard yards behind them, the sustainability of individual country fiscal situations has certainly improved, allowing them to strike a better balance between supporting demand conditions and curbing public sector indebtedness. In addition, the Juncker plan to support growth with additional

spending appears to be gaining some traction and should provide capital to areas where there is a strong disincentive for private sector investment, such as infrastructure and energy. By using only €21 billion of public money, and a dash of financial engineering, the plan aims to produce €315 billion of investment over the next 3 years. According to Societe Generale, projects worth over €1.5 trillion have already been submitted, primarily focused on the sectors listed above. The financial engineering for the plan needs private sector investment into the securitized products it generates. With bond yields already incredibly low, risk tolerance at reasonable levels, and now a significant chunk of sovereign debt being bought by the ECB, it is likely investors will look favourably upon these securities. The plan therefore looks set to form one plank of the greater fiscal support the economy needs.

EXHIBIT 5: GOVERNMENT FISCAL TIGHTENING

Decline in structural deficit* as % of GDP

UK U.S. Eurozone** Japan

5

%

4

3

2

1

0

2010-20132013-2016F

Source: IMF World Economic Outlook October 2014, FactSet, J.P. Morgan Asset Management. *Structural deficit is the cyclically adjusted budget deficit or the deficit that would prevail if the economy were running at full capacity. **Eurozone data is change between 2013 and 2015 due to data availability. Data as of January 31, 2015. For illustrative purposes only.

Unfortunately for investors, the factors supporting the economy and improved equity market performance mentioned above are threatened by political developments. The victory of the anti-austerity party, Syriza, in Greece’s election this January has highlighted the potential for politics to cause significant market moves. The Athens Stock Exchange has fallen by 12.6% since the election announcement in late December. Greek 10-year bond yields increased 133 basis points in January as uncertainty looms over the future of Greek debt. For now, investors recognize that Greece no longer presents the same systematic risk it did back in 2012, and other markets have not reacted in the same way they did back then. However, such calm reactions to the coming elections this year, including in another Eurozone periphery country Spain, are far from guaranteed.


European options outside the Eurozone On balance, we believe that the economic tailwinds in the Eurozone are now stronger than the political headwinds. However, Europe is more than just the Eurozone and investors who wish to maintain exposure to the continent whilst avoiding the single currency area have many options. By constructing a “Europe ex-EMU” portfolio, we can assess just what these options provide an investor in terms of country and sector exposure. Our portfolio contains six countries: the UK, Switzerland, Sweden, Norway, Poland and Hungary. It may come as a surprise to investors, but the MSCI indices of these countries have a greater combined market capitalization than those of the Eurozone’s. The primary driver of this comes from the inclusion of the UK and Switzerland, which are the two largest equity markets in all of Europe. Not surprisingly, those countries make up a massive proportion of the ex-EMU portfolio: 84% to be exact. It is unlikely that an investor wishing for broad exposure away from the Eurozone would tolerate such country concentration. Hence, in order to analyze realistically attractive options for global investors, we constrained the portfolio in order to limit any country to no more than 25% of the portfolio. In doing so, we necessarily shrink the size of the investible universe. Our “Europe ex-EMU constrained” portfolio has a market capitalization of €3.3 trillion which is still 99% of the size of the EMU Index. Exhibits 6, 7 and 8 display details of these portfolios.

EXHIBIT 7: EQUITIES PORTFOLIO FOR EMU AND EUROPE EX-EMU (UK, SWITZERLAND, SWEDEN 25% CONSTRAINED)

Country breakdown

UK

SwedenSwitzerland

Denmark

PolandNorway

Austria

FinlandBelgium

France

IrelandGermany

14%

6%

9%

11%

32%

31%

7%

25%

25%25%

4%

1%

0%

1% 4%3%

0%

Source: MSCI, FactSet, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only.

The constrained ex-EMU portfolio is still more concentrated in terms of country exposure than Eurozone equity index, but in terms of sectors it is similarly diversified. This makes intuitive sense as combined developed markets such as the UK and Switzerland (which themselves have very different sector compositions) with both Nordic countries, along with a splash of emerging markets in Poland and Hungary, would clearly create a diverse portfolio from a sector standpoint.

EXHIBIT 8: EQUITIES PORTFOLIO FOR EMU AND EUROPE EX-EMU (UK, SWITZERLAND, SWEDEN 25% CONSTRAINED)

Sector breakdown

Energy

IndustrialsMaterials

Cons. Disc.

Health CareCons. Staples

Energy

IndustrialsMaterials

Cons. Disc.

Health CareCons. Staples

Financials

6%6% 5% 2% 4% 1% 5%

8%

13%

14%

11%9%

23%

6%

11%

7%

16%26%

21%

6%

Source: MSCI, FactSet, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only.

EXHIBIT 6: OVERVIEW OF EUROPEAN EQUITY PORTFOLIOS

# of

companies# of

countries

Market value

(€ mn) Country Sector

Europe 467 17 € 6,902,138 0.17 0.13

EMU 239 10 € 3,151,056 0.23 0.13

Europe ex EMU 228 7 € 3,804,843 0.41 0.14

Europe ex EMU constrained*

228 7 € 1,236,375 0.21 0.15

Source: MSCI, FactSet, J.P. Morgan Asset Management. *Constrained index limits the size of UK, Sweden and Switzerland. Data as of January 31, 2015. For illustrative purposes only.

Concentration



V I E W P O I N TEurope is more than the Eurozone, and countries outside the single currency area offer attractive equity options for investors. Such a basket of equities provides broad sector diversification, even when ensuring that no single country accounts for more than a quarter of the portfolio.

Staying inside Europe but outside the Eurozone also opens up interesting fixed income opportunities. Again we constrain the country exposure to prevent excessive country concentration. As Exhibits 9 and 10 show, the market cap of our constructed portfolio is still substantial at € 837 billion euros. However, our portfolio is a much higher quality than the Eurozone sovereign portfolio, with 74% of the bonds currently enjoying AAA status compared with only 20% in the single currency area. Furthermore, investors would enjoy a premium of 0.17% at the ten year maturity if they were to move money from the Eurozone to those European countries that are outside the currency block.

EXHIBIT 9: OVERVIEW OF EUROPEAN FIXED INCOME PORTFOLIOS

# of

countries

Market value (€ bn)

Proportion AAA

Weighted Yield

Concentration Country

Europe 19 € 7,775 39% 1.12% 0.14

EMU 11 € 5,704 20% 0.99% 0.17

Europe ex EMU 8 € 2,071 93% 1.43% 0.66

Europe ex EMU constrained*

8 € 941 74% 1.16% 0.16

Source: Bloomberg, J.P. Morgan Asset Management. *Constrained index limits the size of UK to 20%. Weighted yield is the 10-year bond yield. Market value is calculated using all outstanding debt with a maturity of greater than 1 year. Data as at January 31, 2015. For illustrative purposes only.

EXHIBIT 10: FIXED INCOME PORTFOLIOS FOR EMU AND EUROPE EX-EMU (UK 25% CONSTRAINED)

Country breakdown

UK

PolandDenmark

Switzerland

Czech RepublicSweden

NorwayHungary

Italy

GermanyFrance

Spain

NetherlandsBelgium

AustriaPortugalIreland

2% 2% 1% 0%

6%

6%

5%

25%25%

17%22%

20%

10%

6%

5%4%

15%

13%

12%

Source: Bloomberg, J.P. Morgan Asset Management. *Constrained index limits the size of UK to 20%. Weighted yield is the 10-year bond yield. Market value is calculated using all outstanding debt with a maturity of greater than 1 year. Data as of January 31, 2015. For illustrative purposes only.

V I E W P O I N TThe Europe ex-Eurozone countries are also a compelling option for fixed income investors right now. With higher yields and more AAA credit rating issuances than bond markets of the Eurozone, European nations with their own currency could attract significant inflows as yields in the single currency bloc remain depressed.

In summary, the recent actions by the ECB add to a long list of catalysts for the Eurozone economy and its equity markets, justifying serious consideration of the asset class by investors. Unfortunately, politically driven volatility seems a near certainty throughout 2015. For those considering options in the region but outside of the single currency area, there is an attractive array of diversifying equity opportunities to be had. Fixed income options outside the Eurozone also look appealing, with both higher yields and better credit ratings available in sovereign debt markets.

Investments in fixed income securities are subject to interest rate risk. If rates increase, the value of the investment generally declines.


Emerging markets: Disinflation or deflation?Grace Tam, CFA, Global Market Strategist, Asia

IntroductionUnder normal circumstances, a vehicle can only travel smoothly on the road with properly inflated tires. No one can drive comfortably with badly deflated tires, while overinflated tires may even explode. This is similar in some respects to an economy. Some commentators describe an economy with mild inflation or disinflation (a decrease in the inflation rate) as a “Goldilocks” scenario, meaning an economy that is neither too hot nor too cold. Deflation (when the inflation rate falls below zero) or hyperinflation (a very high and rapidly increasing inflation rate) for a sustained period of time is undesirable, as it hurts economic growth. With the strengthening U.S. dollar and weakening commodity price trends particularly intense recently, investors can expect to see some weaker inflation numbers globally over the next few months. This may test the consensus base case scenario of a global disinflationary environment in 2015, possibly leading to a deflation scare and, in turn, risk-off market conditions. For emerging markets (EM), how big is the deflation risk this year?

Deflation risk is loomingThe significant decline in oil prices obviously provides relief for some emerging markets with elevated inflation, such as Turkey, South Africa, India and Indonesia, as it mitigates their need for a sharp tightening in monetary policies. However, at the same time, the fall in oil prices has come at a time when inflation across many EM countries was already at very low levels. As shown in Exhibit 1, inflation in 9 out of the 20 EM countries covered is currently running well below their respective central banks’ target levels.

In fact, deflation risk, particularly at the producer price index (PPI) level, has been an issue for certain emerging markets for some time. The same table in Exhibit 1 also shows that 11 out of the 20 EM countries have had their PPI in deflationary territory for an extended period of time (negative PPI numbers for more than 10 out of the past 36 months). Negative PPI inflation is generally perceived as having been mainly caused by weakening commodity prices. However, as illustrated in Exhibit 2, since around mid-2014, the core PPI (ex-food and energy) for emerging markets has also been falling, implying that the deflationary trend is now more widespread.

EXHIBIT 1: EMERGING MARKETS INFLATION

CPI

(%YoY)

Central Bank CPI Target/

Forecast (%)

PPI (%YoY)

Months of negative

PPI in past 3 years

EM Asia

China 1.5 3.5 -3.3 34

India 5.0 6.0 0.1 0

Indonesia 8.4 3.0 - 5.0* 10.7 0

Korea 0.8 2.5 - 3.5 -2.0 28

Malaysia 2.7 2.0 - 3.0 -4.4 19

Philippines 2.7 2.0 - 4.0 -2.9 28

Taiwan 0.6 1.5* -4.6 28

Thailand 0.6 1.0 - 4.0 -3.6 8

Latin America

Brazil 6.4 2.5 - 6.5 4.4 0

Chile 4.6 2.0 - 4.0 -3.3 26

Colombia 3.7 2.0 - 4.0 6.3 17

Mexico 4.1 2.0 - 4.0 1.1 0

Peru 3.2 1.0 - 3.0 1.5 8

Europe, Middle East and Africa

Czech Republic 0.1 1.0 - 3.0 -3.7 11

Greece -2.6 2.0 -5.7 19

Hungary -0.9 3.0 0.1 12

Poland -1.0 1.5 - 3.5 -2.5 26

Russia 11.4 4.5 5.7 0

South Africa 5.3 3.0 - 6.0 5.8 0

Turkey 8.2 3.0 - 7.0 6.4 0

Source: HSBC, FactSet, J.P. Morgan Asset Management. Data as of December 31, 2014. Note: * No inflation target framework is implemented. Malaysia has implicit preference. Taiwanese Directorate General of Budget’s forecast for 2014 is 1.5%. 1. Numbers in red indicate that the current CPI inflation is below central bank target/forecast. Numbers in green indicate negative PPI for more than 10 months 2. All CPI numbers are as of December 2014. For South Africa, CPI for urban areas is used. For Peru, CPI for Lima area is used. 3. All PPI numbers are as of December 2014. 4. For Czech Republic and Russia, industrial PPI is used. For Indonesia, WPI is used.



EXHIBIT 2: EM PPI INFLATION

Year-over-year % change

15

12

9

6

3

0

-3

-6'00 '02 '04 '06 '08 '10 '12 '14

%EM Core PPI Inflation

EM Headline PPI Infation

Source: J.P. Morgan Securities, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.

What’s worrying is that PPI deflation pressure appears to be spreading to the consumer price index (CPI). Exhibit 3 shows that oil prices have been driving headline CPI lower in recent months. Furthermore, although oil prices do not determine core CPI directly, this ex-food and energy CPI for emerging markets has also been declining thanks to weaker aggregate demand.

EXHIBIT 3: BRENT CRUDE OIL PRICE AND EM CPI INFLATION

Year-over-year % change

'02 '08'06'04 '10 '12 '14

120

%

80

40

0

-40

-80

8

%

6

4

2

0

EM Core CPI Inflation

EM CPI InflationBrent Crude Oil Price

Source: J.P. Morgan Securities, FactSet, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.

A deflationary spiral will likely be avoidedWe may see some very weak or even negative CPI numbers for emerging markets in the near term. However, we believe that the risk of a deflationary spiral (persistent declines in prices that lead to lower economic production and, in turn, further reductions in prices) for most EM countries is still low in 2015 for the following reasons:

• Unless oil prices continue to fall (which would imply that markets are expecting very depressed global growth this year), the direct impact of weaker oil prices on inflation should be transitory, as a rebound almost always follows a big fall once a bottom is made. Also, the more attractive oil prices become, the more future oil demand should increase, and prices will start to rise once again. Therefore, we could see some rebound in headline CPI inflation numbers later this year.

• With the U.S. economy continuing to strengthen and the European Central Bank joining the Bank of Japan in quantitative easing to stimulate their respective regional economies, we expect global demand for EM exports to gradually pick up this year, lifting the EM core inflation numbers as a result.

• Contrary to the developed world, EM central banks in general have plenty of room to cut interest rates in response to deflation risk, as shown in Exhibit 4. Korea, China, India, Poland and Chile have all reduced interest rates in recent months amid lower inflation pressures, and we expect to see rate cuts in Thailand, Hungary and Turkey in the coming months.

V I E W P O I N TA disinflationary environment in emerging markets in general is still our base case scenario for 2015.

EXHIBIT 4: AVERAGE NOMINAL POLICY RATE DIFFERENCE BETWEEN DM AND EM

% per annum

'08 '09 '10 '11 '12 '13 '14

8%7

6

5

4

3

2

1

0

EM

DM

Source: J.P. Morgan Securities, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only.


Aggressive rate cuts are unlikelyNevertheless, we believe it is less likely that EM policy makers will pursue monetary easing in an aggressive manner. The reasons for taking this view are as follows:

• As mentioned above, weak oil/commodity prices may be temporary.

• As some EM central banks are dealing with rising debt to GDP issues, aggressive easing could fuel a further rise in leverage, contrary to their governments’ intentions. For example, Exhibit 6 shows that the total debt (ex-financials) to GDP ratio for Asia ex-Japan is estimated to have increased to 205% in 2014, a big jump from 144% in 2007, with half of the 10 countries in the region having total debt to GDP ratios above 200%.

• EM countries with a deteriorating current account balance and high external debt will be more reluctant to cut interest rates, as their currencies are potentially more vulnerable to the U.S. Federal Reserve’s monetary policy normalization. They may even raise interest rates in order to stem capital outflows. As shown in Exhibit 7, the current account balance for 4 out of the 6 EM regions has been worsening, while Exhibit 8 demonstrates that external debt as a percentage of GDP for 5 out of the 6 EM regions has been rising.

• Some EM governments are concerned that over-easy monetary policies will lead to further misallocation of financial resources. They would rather focus more on structural reforms to set the stage for more sustainable long-term growth.

EXHIBIT 6: OVERALL DEBT LEVEL ACROSS ASIAN COUNTRIES

% of GDP

0% 50%

AXJ

Hong Kong

Korea

Singapore

China

Thailand

Taiwan

Malaysia

India

Philippines

Indonesia

100% 150% 200% 250%

144

144

205

234

244160

162

150

129135

114101

7277

186

186

223

174251

195278

278

20072014E

Source: CEIC, Haver, IMF, estimate based on Morgan Stanley Research estimates, J.P. Morgan Asset Management. Data as of January 31, 2015. For illustrative purposes only. Overall debt includes household debt, non-financial corporate debt, and general government debt.

Monetary easing is the answerA deflationary trend unfortunately implies that real interest rates are rising, which could prove to be increasingly challenging for emerging markets as domestic growth is already weakening. As shown in Exhibit 5, the gap between real GDP growth and real interest rates has narrowed significantly. Central banks may have no other choice but to ease monetary policies and/or allow some currency depreciation in order to avoid a more acute deflationary mindset from taking hold. EM net oil importing countries are particular beneficiaries, as easing measures provide an additional boost to domestic demand on top of the advantage of lower oil prices.

V I E W P O I N TExpectations of monetary easing in certain emerging markets bode well for their respective equity markets in the short term.

EXHIBIT 5: EM REAL INTEREST RATES AND REAL GDP GROWTH

% per annum Year-over-year % change

'02 '08'06'04 '10 '12 '14

6

%

4

2

0

-2

8

%

6

4

2

0

-2

Real Money Market Rate

Real GDP Growth

Real Policy Rate

Source: Emerging Advisors Group, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only. Money market rates are 3-month money market rates, short-term bond yields, interbank rates, etc. Policy rate, money market rate, CPI inflation and real GDP growth are the average of simple average and weighted average based on 2010 nominal GDP.



EXHIBIT 7: CURRENT ACCOUNT BALANCE ACROSS EM REGIONS

% of GDP, 3-month moving average

'02 '04 '06 '08 '10 '12'00

16

12

8

4

0

-4

-8

%Asia

MEAfrica

Latam

CIS*CEE*

Source: IMF, World Bank, Haver, Emerging Advisors Group, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only. *CEE and CIS are abbreviations for Central and Eastern Europe and Commonwealth of Independent States, respectively.

EXHIBIT 8: EXTERNAL DEBT ACROSS EM REGIONS

% of GDP

'02 '04 '06 '08 '10 '12'00

Asia

MEAfrica

Latam

CIS*CEE*

100

80

60

40

20

0

%

Source: IMF, World Bank, Haver, Emerging Advisors Group, J.P. Morgan Asset Management. Data as of December 31, 2014. For illustrative purposes only. *CEE and CIS are abbreviations for Central and Eastern Europe and Commonwealth of Independent States, respectively.

V I E W P O I N TMonetary easing is not a panacea for long-term stagnation. Once deflationary forces start to subside, EM governments may reverse the easing cycle, re-emphasizing deleveraging and structural reforms.

Investment implicationsTo quote John Maynard Keynes, one of the most influential economists of the 20th century, “…inflation is unjust and deflation is inexpedient. Of the two perhaps deflation is, if we rule out exaggerated inflations such as that of Germany, the worse.” With fears that lower commodity prices are the harbinger of a more generalized decline in inflation, EM central banks may choose to ease their monetary policies in an attempt to prevent their economies from falling into a deflationary trap. This should be a positive for EM equities in the short term.

However, it appears that weaker aggregate demand in emerging markets is becoming a threat not only to core inflation, but also to the longer-term economic growth outlook. Some EM policy makers are well aware of the problems. They have been pushing forward with structural reforms in order to improve the overall productivity of their economies.

Nevertheless, it is never an easy task for EM governments to strike the right balance between economic stimulus and structural reforms. Juggling the two could mean a bumpy road ahead for some emerging markets, forcing investors to differentiate among the good, the bad and the ugly when investing in emerging markets.

Americas

Dr. David P. Kelly, CFAManaging DirectorChief Global StrategistNew York

Andrew D. GoldbergManaging DirectorGlobal Market StrategistNew York

Anastasia V. Amoroso, CFAExecutive DirectorGlobal Market StrategistHouston

James C. Liu, CFAExecutive DirectorGlobal Market StrategistChicago

Julio C. CallegariExecutive DirectorGlobal Market StrategistSao Paulo

David LebovitzVice PresidentGlobal Market StrategistNew York

Gabriela D. SantosVice PresidentGlobal Market StrategistNew York

Ainsley E. WoolridgeMarket AnalystNew York

Hannah J. AndersonMarket AnalystNew York

Abigail B. DwyerMarket AnalystNew York

Europe

Stephanie Flanders Managing DirectorChief Market Strategist, UK & EuropeLondon

Dr. David Stubbs Executive Director Global Market StrategistLondon

Maria Paola Toschi Executive Director Global Market Strategist Milan

Vincent JuvynsExecutive DirectorGlobal Market Strategist Geneva

Tilmann Galler, CFA Executive Director Global Market Strategist Frankfurt

Manuel ArroyoExecutive Director Global Market Strategist Madrid

Lucia Gutierrez Executive Director Global Market Strategist Madrid

Kerry Craig, CFA Vice President Global Market Strategist London

Alexander W. Dryden Market Analyst London

Nandini L. Ramakrishnan Market Analyst London

Asia

Tai HuiManaging DirectorChief Market Strategist, AsiaHong Kong

Geoff LewisExecutive DirectorGlobal Market StrategistHong Kong

Yoshinori ShigemiExecutive DirectorGlobal Market StrategistTokyo

Grace Tam, CFAExecutive DirectorGlobal Market StrategistHong Kong

Ian HuiAssociateGlobal Market StrategistHong Kong

Ben LukAssociateGlobal Market StrategistHong Kong

GLOBAL MARKET INSIGHTS STRATEGY TEAM

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